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Follow the Momentum 🚆
Owen
November 08, 2024
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Welcome to Alternate Universe!
In today’s edition:
We uncover one of the main factors in investing - momentum 🚆
Job opportunities at recently funded European startups 👇
The market’s verdict on Trump 💹
Invest Wisely with The Daily Upside
In this current market landscape, we all face a common challenge.
Many conventional financial news sources are driven by the pursuit of maximum clicks. Consequently, they resort to disingenuous headlines and fear-based tactics to meet their bottom line.
Luckily, we have The Daily Upside. Created by Wall Street insiders and bankers, this fresh, insightful newsletter delivers valuable market insights that go beyond the headlines. And the best part? It’s completely free.
The Crux 🔴
As a bookworm, I am constantly searching for new (mostly non-fiction) books. Unsurprisingly, a good chunk of these is from the investing and finance section, followed by science and history books.
Some end up being duds, others page-turners.
Stocks on the Move by Andreas Clenow was one of the latter.
The book describes momentum-based investing, revealing how hedge funds use systematic strategies to identify and capitalize on trending stocks in the financial markets.
The book led me down a rabbit hole on momentum investing.
My goal was to find something simpler tailored to the retail investor.
Luckily, I stumbled upon a gem of a paper.
🐰🕳️⌚
What 🤔
The study is called “Profitable momentum trading strategies for individual investors” by Bryan Foltice and Thomas Langer.
But first, what is momentum investing?
Momentum investing is an approach where investors buy stocks that have shown strong recent performance, banking on the idea that they will continue to outperform while avoiding those with weaker returns.
Momentum is one of several "factors" in factor investing, a strategy focused on selecting stocks with specific traits believed to drive returns. Other popular factors include value, which seeks undervalued stocks, quality, targeting financially sound companies, and size, favoring stocks of companies with specific market caps like microcaps or mega caps.
Momentum as a factor has been researched since the early 90s. In this seminal paper, the authors showed that significant abnormal returns can be had using this strategy. This suggested that the stock market was not fully efficient as hypothesized by economist Eugene Fama. Fama would later acknowledge momentum as a ‘premier anomaly’ to his hypothesis.
While this seminal work laid a strong foundation for future studies, it assumed zero transaction costs when buying trending stocks. In reality, individual investors must factor in these costs, as they can significantly reduce overall profits.
The aim of this paper by Foltice and Langer was to examine the feasibility of individual investors to profit from buying ‘long-only’ portfolios, without the need to short stocks.
How ⚙️
The paper examines the performance of the top 1-50 stocks on the New York Stock Exchange from July 1st 1991, to December 31st 2010, highlighting investment opportunities for individuals with initial investments between $5K and $1M.
The study included a broad sample of stocks, ranging from 1,786 to 3,121 each month. Stocks with a market value below $20 million were excluded.
The method involved a 6-month evaluation period, where daily closing prices were recorded at the beginning and end of this timeframe. For instance, if the evaluation began in February, it would cover stock prices from February 1 to July 31. Stocks were ranked based on their performance during this period, and portfolios were created with the top-performing stocks (e.g., top 10, 20, 30) for further analysis. The overall returns for each portfolio were calculated by averaging their performances over multiple periods.
Key Findings 📃
All portfolios, on average, outperform the S&P 500 by 0.52% to 2.44% per month.
The highest momentum profits are observed in smaller portfolios, aligning with previous studies.
Portfolio performance improves as the number of top stocks included increases, peaking at 3.07% per month with a portfolio of the top seven stocks, but declines as more stocks are added.
With a trading frequency of once per year, nearly all portfolios still outperform the S&P 500, with those holding the top five to eight stocks achieving the highest gross returns, ranging from 2.66% to 2.96% per month.
In addition to the annual strategy, the authors examined bi-yearly, tri-yearly, quarterly, and bi-monthly trading frequencies to assess how each affects portfolio performance.
When using an overlapping trading strategy, an investor needs to determine how much to invest in each stock based on their chosen trading frequency. To do this, they would first divide their initial investment by the number of trades they plan to make in a year. Then, they would further divide that amount by the number of stocks in their portfolio. The formula for calculating the buying power (BP) for each stock in dollars is:
BP = A/(t-k)
where:
A is the initial investment amount,
t is the trading frequency per year,
k is the number of stocks in the portfolio
The table below shows the optimal trading frequencies and stock holdings for different initial investment amounts.
Relevance 🪙
The authors show that individual investors with at least $5,000 can achieve profitability by buying 5-8 of the top-performing stocks from the past 6 months. After factoring in transaction costs and risk, this approach yields the best returns and monthly alphas, with volatility decreasing faster than performance as trading frequency increases. Depending on portfolio size, the optimal momentum trading frequency ranges from bi-yearly to monthly.
Dig Deeper ⛏️
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Headhunted 🦅
Recently funded private companies need talent! Scout jobs at recently funded European startups, ahead of your competition. 💪
Plato 🇩🇪 - The AI-powered ERP automation platform has closed a €6m pre-seed round. Hiring multiple engineers (link)
Yazen 🇸🇪 - The obesity treatment platform has closed a €19.5m Series A round. Hiring dietitians and developers (link)
iFast Diagnostics 🇬🇧 - The UK startup has raised a €5.9m seed round to tackle antimicrobial resistance. Recruiting a junior mechanical engineer (link)
idwell 🇦🇹 - The prop-tech startup has closed €10m in funding to simplify property management. Sales & PM roles open (link)
Cintoo 🇫🇷 - The cloud-based reality data management company has closed a €37m Series B. Sales, PM & dev roles open (link)
Interestingness📔
📚 New to investing? Grab a PDF copy of my ebook here.
As always, the financial disclaimer!
This is not investment advice. I am not a financial advisor. Make sure to conduct your thorough research before purchasing or selling financial products.